Banks in the Modern Economy - Assignment Example

Extinction of Banks A Paper Submitted to In Partial Fulfillment of the Requirements for the By of Student) (Date) Introduction Banks are facing extinction due to lack of measures to address emerging needs in the financial markets. There is the need to institute measures that embrace innovation in order to avoid extinction. The emergence of mobile financial institutions has given the banks a big blow as the new institutions are providing better and efficient services. Through the perfect market assumption, the Modigliani-Miller (MM) theorem posits that banks have no major roles. Financial innovations and deregulations have enabled the financial markets to achieve perfection with institution that do not adopt deregulatory measures lagging behind in the provision of services to customers1. Financial innovations and deregulation have facilitated contractual agreements with governments seeking to institute reforms adopting relevant measures. Discussion Diminishing roles for banks In the contemporary society, banking institutions are being faced by a likelihood of extinction in case they do not formulate measures of keeping up with the times. The increasingly interconnected world, owing to globalization, is a threat to the banking institutions due to the emergence of mobile financial solutions. Customers are becoming more and more accustomed to faster and time-conscious responses from the companies while banks are lagging behind when it comes to finding means of proactively responding to the needs of their customers2. Lack of relevant targeted offers on the part of the banks is to blame for this development as it is vivid that the banks are not focusing on the needs of their customers. According to Gorton and Rosen (1993, p. 22), banks have plenty of funds to invest but are unable to notice emerging opportunities in the financial world. In the light of this, there is a need for the banks to see themselves as not only playing the traditional role of banking but also providing customer services that go beyond convectional boundaries of their present duties. Banks have for a long time been playing the role of consumer trusted advisors but this trust is slowly fading. In case necessary measures are not instituted to embrace innovation in order to capture newer grounds, the banks will lose out. Brigham and Ehrhardt (2010, p. 565) indicate that in the near future, customers will realize that they do not need banks but they need banking services. This will be a dangerous scenario for banks, as they will be at the verge of becoming extinct just like dinosaurs3. In addressing this problem, the banks need to have a new outlook. Investing in innovation will be instrumental in boosting banking operations. Moreover, bankers need to find other avenues of inspiration in order to secure a wide customer base. Although the technology that banks need in order to become responsive to the needs of their customers and in order to open up new streams of revenues already exists, the banks can look up to other avenues. Among these avenues are algorithmic trading, borrowing technology from the telecommunications industries and offering services that are location-based. Consequently, the banks can make use of information about what customers are likely to buy and when to develop new and more targeted products and services4. There is the need by the future banks to embrace technologies from various sectors in order to respond to customers’ actions and turn such scenarios into opportunities for securing more revenue and garnering consumer loyalty. In the near future, consumer will be buying most of their items on their credit card and this will enable them to access promotions and offers from traders in their vicinity. These traders are also banks’ customers who are likely to be bought in by the banks since the providers of their payments become an important avenue of accessing new customers. There is the need to tap into the trends of the consumers, if the banks are keen on surviving the looming evolutionary moment. Embracing innovation is the only way banks will avoid extinction5. The Modigliani-Miller (MM) Theory The Modigliani-Miller (MM) theorem is a theory in business finance, which proposes that the capital structure is irrelevant. Prior to this theorem, there was no theory on capital structure that was generally accepted. The two theorists assume that the firm has a set of cash flows that are expected in the future. When the firm decides to choose a certain fraction of equity and debts to finance its assets, it divides the cash flow among the investors. Firms and investors are assumed to have similar access to financial markets and this allows them to have homemade leverage. Investors can create leverage that was wanted but was not offered or they can get rid of the leverage that was taken by the firm albeit unwanted. Consequently, the firm’s leverage does not affect the firm’s market value6. The MM theory is a cornerstone of contemporary corporate finance. Some of the propositions in this theory reveal that financial institutions such as banks are becoming irrelevant. The theory proposes that under conditions of uncertainty, the debt-equity ratio of a firm has no effect on the market value of the firm. Second, the firms leverage has no influence on the weighted average of the cost of capital. Third, the market value of the firm is independent of the divided policy adopted by the firm. Fourth, equity-holders are not concerned about the financial policy of the firm7. The main contribution of this theorem is that it offers a representation of formal uses of an argument without the possibility of arbitrage. This theorem assumes that particular firms belong to a risk class, which is asset of firms that have common earnings. In case financial market is unaffected by taxes, bankruptcy or transaction costs, imperfect information or frictions that may limit its access to credits, the investors can replicate the firm’s financial actions at no cost. This development gives investors ability to revise firms’ decisions if the desire arises8. Financial innovations, deregulation, and the perfection of financial markets According to Snyder (2011, p. 2), most of the phenomenal changes experienced in financial markets recently have been due to financial innovations and deregulation of the banks. Owing to the transformation of the financial markets, consumers are nowadays able to choose from a comprehensive menu of mortgages that offer flexibility in almost all dimensions. Presently, most lenders are holding mortgages for short periods of time while selling the mortgages on secondary markets. Subsequently, financial intermediaries pool the mortgages together with other mortgages and sell the resulting cash flow into a complex security9. Financial innovations and deregulations are transformations that have increased inefficiency through the integration of mortgage markets with financial markets. Particularly, housing finance has experienced improvements. Institutions that are financial deregulated have combined revolutionary advances in creating banking-related technologies that have intensified the search for opportunities to maximize income gains. Financial innovation and deregulation has taken the form of modern contractual agreements and the development of new financial products, which are less costly and rapidly implemented. Financial innovators have interests in making new financial products and services that are complex in order to make them less copied10. Snyder (2011, p. 3) indicates that deregulation of financial industries has gained popularity in the current financial markets due to the perceived gains of microeconomic efficiency. Moreover, technological innovations in financial institutions have changed opportunities, costs and competitive relations that exist in the markets. Some of the regulations under financial innovations had been abandoned in the past following complexities in enforcing them11. Through deregulation the financial industry has amassed benefits such as provision of public services, financial intermediation, access of the financial market at a lower cost and the availability of products that possess diverse needs and tastes. Furthermore, the menu of assets and liabilities that have been availed by financial innovations and deregulation have accommodated diverse attitudes towards risk. According to Snyder (2011, p. 4), deregulation and financial innovations have not only lowered costs but have also increased options to businesses and investors. This is one of the aspects that have made them serve as tools for perfection of financial markets. Investors have been enabled to shop around and invest their money in liquid funds. Some of the measures used in deregulation in financial markets includes the abolition of commission charges, which leads to a significant increase in the market activities, and the alteration of the market structure12. The use of deregulation has become a cornerstone in governments seeking to institute financial reforms. The reforms that are adopted during deregulation are mainly to enhance competition with foreign banks. Banks that fail to adopt deregulatory measures and financial innovations experience decline and are unable to compete in the global market. Through the adoption of deregulatory measures, the financial capital of a bank is bound to be strong. This comes after a financial boom that is achieved through financial innovation and the emergence of new entrants who provide better and more dynamic services13. Diminishing of bank roles under perfect market assumption of MM theory Existence of banks and their roles in the modern economy has become a major debate among economists and financial observers. Over the years, world economy has taken a radical change especially in the banking system. Globalization in the financial market has been one of the major forces that have changed the character and roles of banks. Researchers suggest that under perfect market assumption of MM theory, banks are in critical condition in the current economy14. Their survival can only be enhanced through formation of regulations that will govern this industry. This is because existence of banks in the economy is based on their ability to minimize intermediary costs. In addition, specialized services and economies of scale allows banks to perform their intermediary functions effectively. However, in a competent financial market, low transaction cost that match their surplus and spending units diminishes role of banks as providers of minimal cost services15. Following the assumption of perfect market, banks’ special roles are diminished and replicated by individual agents. According to micro and macroeconomic prospective, banks hold special roles in their transmission means of monetary policy. Economic credit channels proposes that banks are important not because of their liabilities but because of their lending activities16. Effect of monetary policy in the real economy is greatly enhanced by leading capacity of banks. However, lending view of a bank rests on the claims that there are vital departures from Modigliani-Miller (MM) Theory for banking systems. This is because financial sectors are characterized by asymmetric information in the monetary policy. This is because when central banks around the world hold their monetary policy, other banks are forced to substitute their deposit finance into non-deposit finance. In addition, this portfolio of reallocation makes banks to adjust their asset holdings leading to increase of security rates. Modigliani-Miller (MM) Theory that assumes dividends in the financial market is irrelevant. Its irrelevance indicates that firm’s value is unaffected by distribution of dividends in the market but depends on its earning influence17. Additionally, under perfect market conditions, market price shares are highly affected by lack of tax, irrational investors and the difference between income from dividends and capital. Banking systems are therefore, affected by various MM model assumptions leading to high chance of their extinction in the modern economy. This model assumes that existence of investors and capital market is rational. This indicates that information in the financial market is available to everyone at no cost. Moreover, there is no investor with capability of influencing market securities and price because there is no transaction and floatation cost. MM theory has, therefore, examined the impact of change in debt proportion in banks’ capital structures concerning their resource and value allocations18. This is because the theorem offers an impending world where participants in the financial market acquire relevant information without incurring cost. In addition, perfect market allows free entry and existence of entrepreneurs in the market without taxes and cost barriers. One major implication of this theorem is that firms facing financial crises will not increase investors’ wealth. Scopes of bank activities are highly affected by MM theory because of their major roles in financing firm activities in the economy. In addition, banks also allow investors to avoid reduction in their returns. This is enhanced by offering customized products thus boosting their risk management. Literature for the change of bank’s roles in today’s economy There are various literature and evidence that have been stipulated by economists to give analysis and description of changing roles of banks in the modern global economy. Tradeoffs risk-return is one of the major literatures that show the relationships between returns in investments and risks entitled to them. In this case, risks are inversely related to uncertainties of gaining returns19. Investing in bank’s saving account will involve engaging into a risk especially if deposit costs are incurred and there are uncertainties about future market prospects. Banks on the other hand, play a major role in the economy by taking investors’ savings and investing them in assets and enterprises that generate returns. However, their justification in the market is based on their role to improve tradeoffs risk-return in the economy’s financial market. Capital asset pricing model according to macroeconomics policies suggests that assets are infinitely divisible thus investors with small endowment have chances of constructing their market portfolio. This gives all types of investors a chance to invest in the financial market regardless of their financial status. This is greatly influenced by MM model, which states that capital cost is independent of deposits and cost of debt is equivalent to the cost of equity. Interest rate is, therefore, excluded during loan repayment. In this case, risks are embedded to financial institutions which depend on interest rate earned during money lending to investors. Option pricing is another model that allows investors to manage their risks through buying and selling premiums based on security. This is because MM theorem assumes that investors have knowledge of their future investment and profit expected in the firm. Investors therefore, do not have to necessarily hold securities existing in the market portfolio. This forces financial institutions to offer innovative products that will enhance risk management to investors20. Banks have, therefore, been affected by pricing option in the modern economy. This is because in the current world, investors’ decisions are definite and rational because they have to evaluate risks before embarking on investment proposal. Agency theory is another model that offers instant removal of distortions available in the pricing securities. In this case, prices reflect available information in financial markets. Firms, therefore, have their own investment policies that are constant throughout. This implies that financing of investment from reserved earnings will not change business risks which in turn do not change the required rate of return. In addition, banks play an important role of mitigating agency problems by holding accountability of equity management and extending loans for the investors21. On the contrary, MM hypothesis indicates that only equity and debt are issued by the bank in case firms need loans and their debts have no risks. In such situations, economy raises moral hazards concerning management of the bank. Moral hazard occurs when creditors borrow money from the banks with believes that the government will bail them out. This is an implicit guarantee offered by the government preventing banks from perusing sound management. This is one of the issues that should be addressed in the modern economy to prevent banks from getting extinct due to crises undertaken in the market. Evidence of risk dimension in the modern banking industry Banks in the modern economy incur ambiguous cost when they accept deposits from people. Portion of amount deposited is reinvested by the banks in order to provide depositors with interest out of their deposits. On the other hand, banks face risks from the same deposits due to the difference of magnitude between cash inflow and outflow. In case banks make loans using certain deposits and later receive payment before these deposits matures, they end up reinvesting. If reinvestment rate is lower than the initial deposit, the bank incur a loss. This is an example of reinvestment risk which is associated with interest rate. The risk occurs due to Modigliani-Miller (MM) model, which states that banking systems should not have liquidation and financial distress22. Moreover, under liquidation circumstances of the bank, shareholders should receive amount equivalent to value in the market, plus share of their deposit before liquidation. Similarly, depositors do not incur any cost from their premature withdrawals. This is because according to MM theorem, depositors can withdraw their money earlier that banks’ expectations. In this case, banks have to raise funds either from other depositors or sell their assets in order to repay the depositors. Due to decline of asset value as a result of rise in interest rates, banks will incur liquidity risks. This is because their profit margin will decrease as a result of increase in interest rates, which will only favor the depositors. Banks have also faced delinquency risks in the modern economy. This kind of risk is noted when the depositors perceive investment undertaken by the banks as risky. In this case, depositors will tend to withdraw their savings for safety23. This highly threatens existence of banks in the economy. In addition, banks face systemic risks when depositors panic and withdraw from saving in a particular bank. In other situations, when banks engage in cross boarder businesses they encounter foreign exchange risks. This is because during exchange, they face differentiated regulatory, fiscal and legal barriers. Conclusion Banks in the modern economy play a key role in conduction of monetary policy in the financial market. The main role of banks is based on their objectives of maximizing profits under loan commitment arrangements. However, their objectives are faced with risks of interest rate uncertainties. Modern explanation of asymmetry information justifies influence of banks intermediation activities. Despite their major contribution in the economy, researchers predict their extinction due to influence of perfect market assumptions of Modigliani-Miller (MM) model. This theorem assumes irrelevance of taxpaying, interest rate for depositors and dividends to shareholders. This affects risk return tradeoffs towards investors and threatens existence of banks. 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